Marginal and Effective Tax Rate – What’s the Difference?
- September 11, 2024
- Posted by: CA Sanjeev Kumar
- Category: Taxation
When it comes to tax planning and return preparation, two concepts often confuse most of us – the marginal tax rate and the effective tax rate. While both are crucial for tax planning, they serve different purposes and affect your finances in different ways.–
Read on to understand marginal vs effective tax rate and how it affects the taxes you owe.
Effective Tax Rate
This is the average percentage of your total annual income that you owe as taxes. The effective tax rate is, therefore, the average rate at which an individual or a corporation is taxed on their earned income. To calculate this, you will need two key pieces of information:
- Your total annual income
- Your total federal tax liability
It is calculated by dividing your total tax liability by your total taxable income. The effective tax rate gives an accurate picture of your overall tax burden because it accounts for the different rates applied to different portions of your income.
For example, if you have a total annual income of $100,000 and your total tax is $20,000, your effective tax rate is 20%. Usually, the effective tax rate is much lower than marginal tax rate, which could be as high as 37% as per the 2024 tax slabs defined by the IRS.
Marginal Tax Rate
The marginal tax rate is the percentage of tax you pay on your next dollar of income. In other words, it’s the tax rate that applies to the highest portion of your income.
The United States adopts a progressive tax structure. This means that for every additional level of income, your tax liability increases proportionately. While calculating taxes in this tax structure, the taxpayer’s taxable income is segregated into tax brackets. Each bracket corresponds to a different income range and tax rate.
For example, the marginal tax rates applicable for the year 2024 are as below:
| Tax Rate | For Single Filers | For Married Couples Filing Jointly | For Married Couples Filing Separately | For Head of Household Filers |
| 10% | $11,600 or less | $23,200 or less | $11,600 or less | $16,550 or less |
| 12% | $11,601 to $47,150 | $23,201 to $94,300 | $11,601 to $47,150 | $16,551 to $63,100 |
| 22% | $47,151 to $100,525 | $94,301 to $201,050 | $47,151 to $100,525 | $63,101 to $100,500 |
| 24% | $100,526 to $191,950 | $201,051 to $383,900 | $100,526 to $191,950 | $100,501 to $191,950 |
| 32% | $191,951 to $243,725 | $383,901 to $487,450 | $191,951 to $243,725 | $191,951 to $243,700 |
| 35% | $243,726 to $609,350 | $487,451 to $731,200 | $243726 to $365,600 | $243,701 to $609,350 |
| 37% | Over $609,351 | Over $731,201 | Over $365,601 | Over $609,351 |
Now that you have the table before you, let’s help you understand how taxes are calculated with an example. Let’s assume that you are a married person filing jointly with a total taxable income of $100,000. This is how your tax will be calculated:
| Tax Rate | Tax bracket | Income | Total tax owed |
| 10% | $23,200 or less | $23,200 | $2,320 |
| 12% | $23,201 to $94,300 | $71,100 | $8,532 |
| 22% | $94,301 to $201,050 | $5,700 | $1,254 |
| Total tax owed | $100,000 | $12,106 | |
In the above case, the marginal tax rate would be 22% since this is the bracket under which your last dollar is taxed. However, as you can see, the effective tax rate is just over 12%, since you only pay a tax of $12,106 on a total income of $100,000.
Marginal Tax Rate vs Effective Tax Rate – Why Understanding Both Matters?
Understanding both the marginal and effective tax rates is essential for effective tax planning. Knowing your marginal rate helps you make informed decisions about earning additional income, tax deductions, and investments. Meanwhile, your effective tax rate gives you an overall picture of your tax burden. It’s useful for budgeting, comparing tax burdens year-over-year, and understanding your true financial obligation.
For example, if you’re considering taking on additional work or investing in income-generating assets, knowing your marginal tax rate will help you estimate the tax impact on that extra income. At the same time, knowing your effective tax rate can guide you in making decisions about tax-saving strategies, such as contributions to retirement accounts or charitable donations.
The Bottom Line
Understanding the difference between effective and marginal tax rates can greatly help you understand how much taxes you owe to the authorities and make filing returns easier. However, should you need expert advisors to aid decision-making, Knowvisory’s Tax Consultants are just a click away. Reach out to us to ensure your taxes are managed efficiently and effectively. We can not only help you prepare your returns, but also assist you in minimizing your tax liability, identifying potential savings opportunities, and planning for future tax obligations. Contact us today and navigate your year-end taxes successfully.
